(a)   Pure growth mutual funds.

(b)   Off shore mutual funds.

SECTION – D

In 1991, major changes in the government policy led to the emergence of a market-oriented private enterprise economy through the removal of controls.

The economic liberalisation package compelled banks to improve their profitability. With liberalisation entered the free interest rate regime, which meant that banks had to face interest rate uncertainty. Coupled with this was strict enforcement of SLR requirements for banks to keep the money supply under control. Hence, public sector banks were forced to undertake more trading in government securities. The increase in interest rates on government securities with a longer period of maturity meant capital loss (depreciation) on the holding of old securities. To partly offset this loss, banks began trading of a new instrument—repos or ready forward. Repo is a means of funding by selling a security held on spot (ready) basis and repurchasing it on forward basis.

Several banks, including foreign banks, were unwilling to purchase securities for maintaining SLR because of the risk of depreciation. They preferred ready forward contracts with other banks, which were surplus in securities. These ready forward contracts were turned around every fortnight depending on the banks’ deposit figures. Moreover, many banks had purchased public sector bonds which they could not sell due to the coupon rate hike. Many banks then violated the Reserve Bank advice and entered into ready forward deals in PSU bonds.

Repos are a legal and versatile instrument but the inter-bank repos in 1991-92 were based on some inside information obtained illegally. Besides obtaining information illegally, most of the ready forward deals were dubious and facilities like Bank Receipts (BRs) and SGL forms were misused. Bank receipts which were working smoothly as a mechanism (acknowledgement) for transfer of government securities amongst banks were highly misused. There were fake bank receipts in circulation and there was double counting of BRs, which led to an accelerated growth in money supply.

Most banks, with a view to increasing their profits, employed their clients’ funds in stocks through their brokers. This they did by offering higher returns through portfolio management.

The stock market index—BSE Sensex—rose by leaps and bounds. Harshad Mehta, by injecting the banks’ money into share trading, pushed up prices of selected scrips. Besides the banks’ funds, he tapped another source of money—mutual funds. The government was encouraging the creation of mutual funds. These mutual funds, in order to increase their popularity, assured higher returns which led to sizable flow of money to the stock market. Moreover, certain industrialists engaged themselves in ‘insider trading’ to raise the prices of their shares to prevent hostile takeovers.  Brokers, with so much money in their hands, were successful in raising the Sensex by 1,500 points in 15 days.

The boom, which began in July 1991, peaked in April 1992, before the bubble burst. Prices of many scrips such as Apollo Tyres, ACC, Castrol India, East India Hotels, GE Shipping, GNFC, Deepak Fertilisers, and Tata Chemicals shot up three times their usual value in just a year’s time.

Between March 1991 and March 1992, the BSE sensitive index rose by more than three and a half times—from 1,168 to 4,285. At the peak level, the market capitalisation of Rs 3 lakh crore was about half of the GDP as compared to hardly one-fifth of the GDP the previous year. The market price-earning (P/E) ratio at 55 was not only higher than what it was in many other developing and developed countries but was far in excess of the fundamentals. The monetary size of the securities fraud was estimated to be Rs 3,542 crore. The Sensex dropped to 3,000 and the BSE was closed for a month when the scam came to light.

The scam highlighted the loopholes in the financial system, unfair trade practices in various instruments, widespread corruption, and wrong policies. The Reserve Bank banned inter-bank repos after the scam and the pace of reforms in the financial sector also increased.

Questions:

a.      Highlight atleast four loopholes in the Indian Financial System during the early 1990’s.

b.      Give a brief account of the unfair trade practice carried out by Harshad Mehta.

c.       Give your recommendations to avoid such a situation in the future.